Article by John Hiddleston, senior manager, Horwath Clark Whitehill, and Manuela Oberhofer, German tax lawyer, AWT Allgemeine Wirtschaftstreuhand, published in the May 2001 issue of Tax Adviser In the UK, we have now started on the familiar annual process that begins with the Budget of 7 March, proceeds through a Finance Bill and eventually emerges as a fully-fledged Finance Act. What are our European cousins doing? What, for example have they been up to in Germany?
Last year the Germans passed the Tax Reform 2000 Act and the Tax Relief Act. These represent a major change to the German tax system, particularly to the way business is taxed. The changes generally came into force on 1 January 2001.
Central to the reforms are reductions in income and corporation tax.
Reduction of income tax
The 2002 stage of the Tax Relief Act 1999–2000–2002 is brought forward by one year to 1 January 2001. The basic personal allowance is increased from approx. DM 12,300 in 1998 to approximately DM 14,000 in 2001. Over the same period, the basic rate of income tax falls from 25.9 per cent to 19.9 per cent. The top rate is cut also step-by-step – from 53 per cent in 1998 to 48.5 per cent by 2001.
As from 1 January 2003, the basic personal allowance will be increased to DM 14,500. The basic income tax rate will be cut to 17 per cent while the top rate will be brought
down to 47 per cent.
As from 1 January 2005, the basic personal allowance will be increased to DM 15,000. The basic income tax rate will be reduced to 15 per cent while the top rate will be cut to 42 per cent as a result of the Bundesrat resolution. The top rate will be applied only to taxable income in excess of DM 102,000. This will help to mitigate the progressive increase in the tax rate for middle-income earners.
This compares with modest changes (e.g. to the ten per cent income tax band) in the UK Budget.
Reduction of corporation tax
The reduction in corporation tax is accompanied by a change in the system of taxing corporations and shareholders.
The German corporate tax rate is cut to a uniform 25 per cent as from 2001. However, subsidiary taxes and local trade taxes take the effective rate for a company to a total tax rate of about 38.60 per cent.
As regards the taxation of dividends, the full imputation system is applicable in 2001 for the last time. From 2002 onwards the full imputation system will be replaced by the so-called half-income system to make cross-border investment within Europe more attractive. Under this system, only half of the distributed profits of a corporation will be included in the shareholder’s personal income tax base. In return, it will be no longer necessary to credit the corporation tax paid by the company against the shareholders’ income tax.
Germany did away with ACT several Budgets ago.
German capital gains from the sale of shareholdings between corporations will generally be exempted from tax. In order to prevent abuse, however, various restrictions will be imposed. The new rules will enter into effect as from the 2002 tax year.
In Germany there is no division of taxes into a ‘capital gains tax’ on the one hand, and ‘income tax’ on the other. The profit arising on a sale of shares is simply a special source of taxable income. With the Tax Reform 2000 Act half of the dividends paid to the individual shareholders and under certain conditions half of the gains from the disposal of the private shareholders’ share are taxed under the income taxation rules.
Private shareholders will be able to sell their stakes in corporations after a minimum holding period of one year without paying tax as before, unless they have a substantial interest. However, the threshold for what constitutes a substantial interest will be reduced from ten per cent to one per cent as from the 2002 tax year. If the sale is subject to tax, i.e. when shares are sold within the one-year holding period or represent a substantial interest – the half-income method will apply from 2002 onwards.
These measures have no direct equivalent in the UK.
The German Government hopes that these fundamental reforms will decisively improve the international competitiveness of German industry. It hopes that the changes will result in simple and transparent taxation of corporations and their shareholders, creating a system that is in line with European practice and less prone to abuse. A study issued by the German Federal Ministry of Finance which compares the corporate tax system among EU Member states, Japan, Canada, Switzerland and the United States shows Italy and Germany to be the only countries with a full imputation system. Full imputation has been criticised in Germany for being highly complex and (among German tax inspectors) for offering ‘undesirable tax avoidance’ opportunities; furthermore, its compliance with EC law has been questioned since imputation credit is granted only for dividends distributed by German resident companies. The intention is that companies, especially small and medium sized entities, will have an incentive to finance themselves from retained earnings, thus promoting investment and job creation. In particular it will be interesting to observe how the exemption of capital gains from the sale of shareholdings impacts on companies’ flexibility andresponsiveness to changing business conditions. The intended effect is that Germany could become a tax-efficient holding company location because of the possibility of tax free disposal of shares between companies and of the tax free distribution of dividends between companies.
The German business landscape is characterised by a strong presence of small-and medium-sized enterprises, the so called Mittelstand. The Mittelstand comprises companies with staff numbers of below 500 and an annual turnover that does not exceed DM 1m (small companies) or DM 100m (medium sized companies).
In Germany, there are 81 per cent small companies (DM 32,500 up to DM 1m), 19 per cent medium sized companies (DM 1m up to 100m) and large companies (above DM 100m). The Mittelstand is enormously important to the Germany economy.
While 84 per cent of all businesses in Germany are organised as unincorporated businesses or sole traders subject to income tax, the number of corporations subject to corporate tax is one fifth the proportion in the UK, accounting for only 16 per
The reform elements of the Tax Reform 2000 Act are focused on this Mittelstand, which means for unincorporated business especially the following measures:
• Unincorporated businesses in Germany will benefit from significant cuts in income tax rates.
• Businesses that derive income from trade or business and are liable to local trade taxes will see an additional reduction of their tax burden in view of technical changes to the way in which trade taxes are relieved for income tax purposes.
• The tax-free allowance for the sale or closure of a business will be raised from DM 60,000 to DM 100,000. In addition, the ‘half-average tax rate’ abolished in 1999 will be reintroduced in accordance with the Bundesrat resolution for entrepreneurs retiring from business. This benefit can be claimed once in a lifetime by entrepreneurs having reached the age of 55. This has some similarities with CGT retirement relief which the UK is phasing out.
• The restructuring of unincorporated businesses by way of a tax-neutral transfer of undisclosed reserves will be facilitated by reintroducing the so-called ‘co-partner tax remission’.
At one stage it was proposed that unincorporated businesses would be able to opt for taxation as companies but this has been dropped now that the top rate of income tax has been further reduced.
Financing the tax reform
In the measures adopted to finance the reform, principal emphasis has been placed on restricting existing tax depreciation arrangements:
• The declining-balance tax depreciation rate for moveable assets will be reduced from 30 to 20 per cent.
• The depreciation rate for company buildings will fall from four to three per cent.
• As from 2001, the official depreciation rate tables are to be based on more realistic useful life periods.
• The rules on shareholder debt financing will be brought into line with international practice. The capitalisation rules will be tightened from 2001 with respect to the debt/equity ratios which grant ‘safe havens’.
Other measures highlighted
Many German employers still use old paper copies of the German equivalent of our PAYE tables. These are denominated in Deutschmarks. There are no plans to issue any more copies in paper form because the assumption is everyone is computerising. However, the Euro is now in place; indeed national currency units (Deutschmarks) will be abolished with effect from 1 January 2002. This could have made life very complicated for many employers, faced with applying Deutschmarks denominated PAYE tables to wages and salaries denominated in Euros and arriving at a tax to pay figure also in Euros. So Tax Reform 2000 switches employers over to using a simple mathematical formula. Who knows, perhaps there is a model here for our tax authorities if we ever adopt the Euro?
The authorities will have the right to access online electronically kept books and records of companies in the course of field audits. This measure will not be introduced before 2002. As from 2002, electronic records will be accepted as invoices for VAT purposes subject to certain conditions. This comes in response to the call from business undertakings for simpler taxation.
In its literature, the German government claims that in the period from 1998 to 2005, taxpayers will benefit substantially from net tax relief totalling more than DM 93 billion (say £28 billion) thanks to the Tax Reform 2000 Act, the Tax Reductions Act 1999–2000–2002 adopted last year, the Family Benefits Act and other reform measures.
Gordon ‘Iron Chancellor’ Brown has not seen fit to dispense largesse on such a grand scale. How are the Germans able to do it? The answer is that budget discussions (the comparison of government revenue and expenditure) are carried out separately from legislation such as a Tax Reform. Of the DM 93 billion of ‘cuts’ mentioned above DM 62.5 billion will be financed principally by a change in the way tax depreciation rates are calculated – so there aren’t really cuts in net terms at all. To cynical Britons the word ‘spin’ perhaps springs to mind. However, in Germany Tax Reform 2000 Act is widely admired as a major improvement to business taxation (the truth is, the Germans simply do things in a slightly different way from the Brits).
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May 2001 by